This invention relates generally to a system and method for monitoring the US tax status of non-resident individuals, and in particular to an interactive knowledge based system for monitoring the combined effect of an individual's visa and travel activities, international tax treaties, and the presence or absence of potentially taxable income over specified periods of time.
Foreign students and scholars and foreign employees who come to the United States temporarily to study or work, may or may not be subject to Federal income taxation in the United States, depending on the type of income they earn while in the United States, the type of visa history they have (such as whether they are considered tax resident or not), the type of work activities performed and whether or not they can obtain the benefit of any international tax treaties that may be applicable to their situation. Institutions that employ or make payments such as fellowship or scholarship grants to such individuals need to comply with the applicable laws in order to withhold the appropriate amounts from payments to or on behalf of such individuals and file appropriate reports with taxing authorities.
Most institutions that have been faced with this problem try to deal with each individual on a case by case basis, but find this difficult to implement, if it can be done at all, given the institution's resources. A case by case analysis, however, is the approach suggested by the United States Internal Revenue Service.
While the United States has a "Model Treaty" it uses for international tax negotiations with other countries as a guide that might help standardize treaty terms, this does not contain provisions for teachers and only limited provisions for students. Thus, exemptions that might apply to these types of employees are developed during negotiations with a particular foreign country and, consequently, vary from treaty to treaty. Hence the reason why the IRS suggests the case by case approach.
In many cases, the treaty will have what is known as a "saving clause," a provision in most tax treaties negotiated with the US, which provides that the US reserves the right to tax its citizens and residents as if the treaty did not exist. This means that a critical determination for each individual (and the institution monitoring his or her tax status for withholding purposes) is whether the US considers the individual to be a resident for tax purposes. A resident alien for tax (but not necessarily immigration purposes) is one who had the right of legal permanent residence in the US or who passes the substantial presence test (the individual was present in the US for a specified minimum number of days.) Individuals who are thus deemed residents for tax purposes normally lose any treaty exemptions. However, some treaties have exceptions to this exception for teachers, researchers and students, so long as these individuals do not have status as lawful permanent residents. These exceptions are unique to each treaty.
In addition, the language of each treaty may be unique, so that an exemption that may be provided for teachers, for example, may not be available under that same treaty for researchers.
Further complicating the problem, some treaties also limit how much of an individual's income is exempt and for how long a time. These provisions, too, differ by treaty.
Individuals who come to the United States as students or researchers and stay for a while longer as teachers also need to be concerned about consecutive exemptions. Some treaties allow an individual to have consecutive exemptions without returning to the home country in between. However, many do not. In these latter cases, the individual may not be entitled to a further exemption unless he or she returns to his or her home country for at least a year.
In attempting to deal with this situation, the individual and the institution must understand the individual's residence status not only from a tax and tax treaty perspective, but from an immigration law perspective as well. While nonresident status protects foreign-source income from US tax, it is usually advantageous for most individuals whose primary source of income derives from US sources to file resident tax returns in the US.
For example, students present in the US with F,J, M and Q visa status are required by law to file taxes as nonresident aliens for their first five years in the United States. Visa subclassifications that authorize employment in the US are:
F-1--students and trainees in academic language programs. These individuals may work in a curriculum related job program or on-campus job and are exempt from FICA for the first five years, usually.
J-1--for students, trainees professors, research scholars and specialists--these may be employed in a curriculum-related job or on campus provided they comply with visa requirements. They are usually exempt from FICA withholding while they are nonresidents, usually two years.
H-1--for individuals of distinguished merit and ability to permit them to work at the sponsoring institution only. These holders are usually not exempt from FICA withholding unless they are covered by a US Social Security Totalization Agreement that provides otherwise.
M-1--for individuals who are students or trainees in vocational institutions.
Q-1--for workers engaged in practical training in cultural traditions and history, for example, to permit them to perform temporary services for the sponsoring institution.
Students who have been in the US since 1988 and who were present for at least 183 days in 1995 would probably qualify as resident taxpayers for the year 1995.
Nonstudents with J visas (professors, scholars, researchers, etc.,) are considered nonresidents for at least their first two post-1984 years in the US. H visa holders must files as nonresident aliens if they do not pass the substantial presence test.
There are three primary ways for qualifying for tax residence:
1. The substantial presence test. Nonimmigrants who hold other than an F,J, M or Q visa and can pass the test for the minimum number of days present and do not have a closer connection to a foreign country than to the US, may qualify. However, F,J, M and Q students and their dependents are not permitted to use the substantial presence test for at least their first five years in the US. Nonstudent J's and Q's may not use the test for at least two years. Holders of diplomatic/consular status or individuals employed by international organizations are also exempt from the substantial presence test--that is, they remain non-residents for tax purposes.
2. Married individuals may also become tax resident through certain elections. However, there are a number of provisions related to this, as well.
3. US Permanent Residency. Individuals must file as US residents if they have been given the legal right to reside permanently in the US, and this right is granted at the time of the final interview with the Immigration and Nationalization service (INS) even if the "green card" does not arrive for some time. However, individuals who obtain their "green card" overseas, are only taxed from the first day they enter the US, unless they meet the substantial presence test. Special "dual-status" rules apply to individuals who obtain permanent residence with fewer than 183 days remaining in the tax year and who do not pass the substantial presence test or otherwise qualify as tax residents for the full calendar year.
Institutions who employ or make payments to foreign students, teachers and scholars, are required to report to the IRS the amounts paid, and taxes withheld for employees or payees who are tax resident aliens, using standard W-2 and 1099 forms. If the institution makes payments, either through payroll or through a scholarship or fellowship office, to an individual who is deemed to be a nonresident for tax purposes, the institution is required to report some of those payments to the IRS on Form 1042S.
Whether an institution likely to employ or pay foreign students or scholars is a business corporation or a university, its payroll system is already extraordinarily complex. Most administrators of payroll systems today must be familiar with laws, rules and systems for topics as diverse as: the earned income credit, garnishments and levies, court-ordered child support, pre-and post-tax IRA contributions, restricted stock awards, deferred compensation plans, cafeteria benefit plans, equal employment opportunity laws, fair labor standards, work and student visas, social security and Medicare, shift differentials, group term life insurance, imputed income, tuition reimbursement, worker's compensation, ACH, OSHA, CODA, accelerated deposit rules, ADA, backup withholding, constructive receipt, de minimis fringe benefits, disability insurance, 401(k) plans, and so on. Most administrators are not familiar with the international tax treaties and their application, however, nor are most of them familiar with the intricacies of residency analysis, visa status review, exemption limits, and other factors that must be taken into account for foreign students, scholars and researchers.
Foreign student enrollment at educational institutions has risen from approximately 150,000 a year in 1970, to almost 450,000 a year in academic year 1993/94. Schools that may have had only a few hundred foreign students in 1970, may have as many as 2500 to 4500 (the range is taken from published data about the 20 institutions with the most foreign students in 1993/94.) Many of the treaties were first negotiated several decades ago, before the surge in frequent, relatively low cost travel by foreign students, scholars and researchers to and from the US. Even the Model Treaty used by the US is based on the OECD model treaty of 1977. Travel patterns then and now for foreign students, scholars and researchers are quite different. Travel patterns may even change the likelihood that a particular treaty will apply.
For example, a U.K. national who was tax resident in Belgium immediately before visiting the United States to teach would be covered by the treaty with Belgium, not the treaty with the U.K. Likewise, an individual may have been resident in a country with which the US has no tax treaty or a country with which the US has a treaty but lacking an article benefitting the individual. As an example of this, a citizen of France who has been living and working in Canada and who next comes to the US to engage in research would be covered by the treaty with Canada, not the treaty with France. Since the treaty with Canada has no treaty article benefitting researchers, the individual would be subject to US tax.
Thus, while it may have been feasible for a payroll administrator to deal with foreign students on a case by case basis, with appropriate help from the accounting, law, and other departments in 1970, it is impractical to do so at a school with an enrollment of several thousand foreign students in 1995, many of whom travel back and forth to this country and possibly other countries several times a year.
For each foreign student, scholar or researcher receiving payment or employment from the institution, the institution must determine if the person is to be treated as
tax resident (US income is reported on form W-2 and 1099, individuals are taxed on worldwide income, may claim same deductions and exemptions as US citizens, and are subject to FICA withholding on their US income), or PA1 not tax resident (Individuals are taxed on most income from US sources, nonwage income is reported on Form 1042s, as are treaty exempt wages and salaries, but all other wages and salaries are reported on form W-2 and taxed at graduated rates based on a form W-4 submission--where only single marital status can be claimed, regardless of actual marital status and only one withholding allowance may be claimed (for most foreign students) and an additional $4.00 a week in withholding must be requested and exempt status under a treaty cannot be claimed) PA1 Scholarship and fellowship grants to nonresident aliens from a foreign source are not taxed, but US source grants are taxable, with a withholding rate of either: PA1 FICA withholding for the nonresident is based upon the substantial presence test, applied in calendar years, not academic years. PA1 include a saving clause (giving the US the right to tax its residents and citizens as if the treaty did not exist); PA1 define what income is taxable; PA1 define tax resident; and, in the case where the United States' definitions of resident conflict with those of the other country, PA1 the individual's status as tax resident or not tax resident, based on the individual's visa and travel history for as far back as the last 6 years, (or more), applying not only Immigration and Naturalization (INS) laws but also IRS rulings, as well as any applicable tie-breaker provisions of any applicable tax treaties; PA1 whether any tax treaty applies (if an individual is a citizen of one country, had been a tax resident of a third country, and is now in the US, one of two or more treaties may apply); PA1 whether any exemptions in any treaty apply to this individual, given this individual's residence status and primary activity in the US; PA1 whether any taxable income exists; PA1 what forms must be used to report and claim the results of the above, both by the individual and by the US institution making payments to him or her.
AND
14% on US source grant income if the nonresident is a degree candidate present in the US under and F-1, J-1, or M-1 or Q-1 visa, and the portion received for tuition expenses is exempt, or PA2 30% if the nonresident is a non-degree candidate and the grant was not made for study training or research at a US institution or was not made by a tax-exempt organization, a foreign or federal, state or local government agency or an international organization, PA2 include a tie-breaker rule for determining treaty residency when an individual is a resident under each country's internal law.
AND
While it may often be advantageous for an individual to file as US tax resident, there are time it may be desirable to retain nonresident status, if possible, since resident aliens are taxed on total worldwide income. Nonresident status may be advantageous if an individual is to protect foreign-source income, such as a home-government scholarship which could be taxable. However, an individual may not choose between resident and nonresident status for tax purposes, as it is determined as a matter of law. A part of the legal determination is based on the terms of any applicable treaty.
Tax treaty provisions generally take precedence over the substantial presence test in determining residence for tax treaty purposes. A wide range of tax exemptions and reductions are available to residents of treaty countries who are temporarily in the US while engaged in qualifying activities. For example, some individuals may be considered as residents of the US under IRS definition and residents of their home country by virtue of tax treaty provisions. This "dual resident" status permits qualifying individuals to claim nonresident status for purposes of income covered by tax treaty, yet be treated as residents for all other purposes of the US tax law.
The problem facing foreign students, scholars, employees and their US institutions in monitoring tax status is formidable. Interpretations of tax treaties and their applicability to an individual require in-depth legal and analytical skills.
Since the 1950's, the United States has entered into tax treaties with other countries that define mechanisms to avoid double taxation of the same income, and procedures for cooperating with each other to resolve tax disputes, enforce compliance and exchange tax information. The bilateral treaties entered into by the US typically cover how each country's residents are taxed and what is taxable income, and include definitions of residence , the scope of the power to tax, and specific exemptions from taxation that may apply. Most tax treaties grant each country broad interpretive powers to the competent authority in each country, if questions arise about the meaning of a provision.
US income tax treaties are negotiated by the Treasury Department and the Treasury Department issues Treasury explanations as official guides to the treaties. Treaties have the same effect as acts of Congress. Under US law, if the terms of a treaty conflict with a US statute, the more recently adopted of the two may prevail, if it is otherwise deemed constitutional. The Treasury Department does not provide detailed regulations for the application of individual income tax treaties, however the Treasury explanations, the Report of the Senate Foreign Relations Committee on the treaty and occasionally, discussions of the treaty on the Senate floor are all used as guides for interpretation of the treaty.
In some cases, a Treasury explanation draws upon US IRS rulings and decisions on the application of treaty provisions.
The US is a party to more than 40 income tax treaties with other countries. Some of these were negotiated before the OECD (Organization for Economic Cooperation and Development) Model treaty was first published in 1977. The treaty with the former Soviet Union covers the CIS member countries that have not yet negotiated new treaties.
Most treaties:
The treaty with Indonesia illustrates a form of a tie-breaker rule. Under it, the first test is whether the individual has a permanent home, e.g. where the individual resides with his or her family. If the person has a permanent home in both countries or in neither of them, he or she is deemed to be a resident of the country with which the individual's economic relations are closer. If that is inconclusive, the deciding factor is where the person has an habitual abode. If the individual has an habitual abode in both countries or in neither of them, the person is deemed to be a resident of the country of which he or she is a citizen. If citizenship fails to assign a single residence, the competent authorities are charged with settling the issue.
Even when the most recent version of the model treaty is used as the basis for negotiations, each treaty is negotiated and each one may have terms that differ from all the others. Treaties are also subject to expiration and renegotiation. In addition, changing national circumstances (such as the dissolution of the USSR) may require additional analysis to determine what, if any, treaty applies.
In order to perform a reasonable case by case analysis of the tax status of a given foreign student, scholar, or researcher, for example, one or more knowledgeable people need to determine:
Each of these may involve a number of additional complex analysis steps. In determining whether any taxable income exists, for example, most treaties also distinguish between income from "independent" and "dependent" services. Income from "independent" services is more commonly known as self-employment income. Many treaties incorporate the rule that an individual who is a resident of a treaty country and who derives income from self-employment in the US will be exempt from US federal tax in respect of that income unless certain conditions are satisfied. These vary by treaty. They may include rules about having a fixed base, or spending a certain number of days in the US, or a minimum amount of self-employment income or some combination of these.
As another example, the saving clause in some treaties may have an exemption for a student at "a recognized" educational institution. Experts in treaty analysis and interpretation know that this usually means an accredited institution, not merely one that is known for offering classes, such as a vocational school. However, those who rely on the ordinary meaning of the word could be misled. While treaty documents are US government works that are not protected by copyright, it is not easy to obtain copies of them without subscribing to costly update services. When copies are available, they are usually published in full, leaving to the experts to find the relevant articles of each treaty which may or may not confer benefits.
Consequently, the person or persons who analyze tax status for institutions should be expert in US tax law, international tax treaties, and US Immigration and Naturalization Law, and have or have access to all the update services necessary to stay current in these areas. Since most institutions do no have one or even several people on staff who have the required specialty knowledge, it may take outside consultations with one or more experts, for each foreign individual. This can be very costly for the institution or the individual or both. As a result, at least one published study from November/December 1994 shows that the level of noncompliance is estimated to be quite high.
In that study, at least half of all foreign students failed to file a US return when they should have, and of those who filed, many filed the wrong form. Both the students and the institution can face liability and penalties for noncompliance, and students who might be eligible for a number of tax treaty benefits may fail to claim them. Students from the countries under study averaged an overall noncompliance rate of 95%. However, this apparently did not cause a loss of revenue to the US, since many of the noncompliant students overpaid US taxes, by failing to claim applicable treaty benefits. Another study shows that some educational institutions may have tax liabilities in the six figures, as audits show that inadequate withholding and reporting of foreign tax status occurred.
Individuals who fail to file tax returns correctly or who have been issued payor documents incorrectly may encounter significant tax penalties and costs from the failure to file and pay appropriately. It has been reported in one study that institutions and individuals who are noncompliant usually have not refused to comply, but simply find it extremely difficult and complicated to do so.
Ideally, an institution that employs or pays foreign students, professors, and researchers, needs to be able to make all the proper determinations about tax status and withhold taxes and file reports accordingly. For an institution with thousands of foreign students, from some of over 40 or more treaty countries, where each student could be on one of 8 or 9 different types of visas, and may or may not have US or foreign source income and may have any number of permutations and combinations of travel history to and from the US per individual, per year, this is not a simple task to do once, much less on an ongoing basis as treaties and laws change, visa status per individual changes, and so on.
Ideally, an individual foreign student, scholar or researcher with potentially taxable income, needs to understand what, if any benefits may be available under applicable tax treaties.
However, attempts by institutions to create computerized payroll or tax analysis systems to handle this involve the further complication of requiring familiarity with systems analysis and complex programming skills, in addition to all the tax law, international tax treaty law and immigration law skills. Conventional mainframe payroll systems to address this problem could cost hundreds of thousands of dollars to develop, and possibly just as much to maintain, if they were deemed feasible to do. Conventional payroll systems work best at handling clear-cut distinctions, such as computing a withholding amount and subtracting it from gross salary, not the constantly changing, subject-to-interpretation environment of international tax treaties, where the question is more likely to be knowing whether any withholding applies at all.
The programming task is complicated even further by the fact that the tax laws and tax treaties generally work on a fiscal year that is the same as the calendar year for determining presence and benefits, while most institutions that employ or pay foreign students and scholars operate on an academic year basis, usually September or October through May or June. Some treaties base physical presence tests on a 12-month consecutive period rather than a calendar year. Many treaties also impose time limits for exemptions. Some of these may be fixed terms, such as 5 calendar years, or they may be defined as the "period" reasonably necessary to complete the education or training. For most undergraduate or college degrees, this period would be 4 years, but for advanced degrees the period might be longer, such as 7 years for medicine. In some cases, an exemption can be lost retroactively if a time limit is exceeded. For example, the U.K. treaty provides that if a person comes to the US for the purpose of teaching, his or her two year exemption from tax will be lost if the person exceeds the 2 year period in the US. The complexity of such time determinations and conversions from fiscal year to calendar year, or academic year, or 12-consecutive months, or "reasonable" period, makes visa history, and computations involving the substantial presence test somewhat daunting.
As further examples, F-1, J-1, M-1 and Q-1 visa holders who are students are exempt from the substantial presence test for five calendar years. But for this purpose, presence in the US for any part of a year is considered presence for that entire calendar year. Thus, a foreign student attending college in the US for four typical academic years would be present for five calendar years.
In another example, J-1 visa holders who are non-students, such as professors researchers and specialists, are exempt from the substantial presence test during the first two calendar years they are in the US as nonresidents. If a J-1 nonstudent holder was exempt from the substantial presence test for any two of the last six years, the individual must compute the substantial presence test for the current calendar year. However, if the J-1 nonstudent holder is paid from a foreign source, he or she must compute the substantial presence test in the current year only if he or she has been exempt under a J-1 visa for any part of four of the previous six years.
If the foreign student, scholar or researcher is from a country with which the US has renegotiated an existing treaty in the last few years, it is also possible that the terms of both the old and the new treaty must be analyzed in conjunction with the individual's travel and visa history over the last 6 or 7 years. Generally, when an old treaty is replaced by a new treaty, a resident of a treaty country has two options. The individual can elect to have the old treaty apply in its entirety for the first year in which the new treaty is effective, if the old treaty results in greater relief from tax. Alternatively, the individual can claim benefits under the new treaty.
Individual foreign students and scholars may need to overcome language, custom and legal system differences to be able to obtain the benefits they are entitled to by treaty and law. In the study of noncompliance mentioned above, it was estimated that the average foreign student's tax liability was about $2,000. If the student has to consult a professional, such as an accountant, tax attorney or immigration law attorney, to understand his or her status, the cost of consultation could easily consume almost the same amount of money, thus negating any treaty benefits that might apply. Professionals who are very experienced in the area might be able to do the analysis in 45 minutes to an hour. However, most accountants, tax attorneys and immigration attorneys, are not familiar with tax treaties. Most accountants do not now maintain up to date treaty resources because of the costs involved. It could take as much as 6 to 8 or more hours for such skilled professionals to research the proper treaty and interpretations, make the determinations and explain them to the individual. At an estimated average fee of $150 an hour, this could cost the student $900 to $1200 or more.
Similarly, institutions with 2500 or 4500 foreign students might find even the experienced professional's one hour per student too costly. At an average fee of $150 an hour, again, multiplied by the number of students, the cost could be $375,000 to $675,000 or more, each year. At the same time, if the institution is not withholding the proper taxes, it could be liable for them. The IRS has stated that the adjustment resulting from audits of institutions in these areas has cost the institutions from $30,000 to $250,000. In one case, where an institution misclassified employment income as scholarships and fellowships, the adjustment contributed significantly to a $50 million liability. If most of the students are eligible for treaty benefits, and file appropriate returns so indicating, the liability risk for the institutions can be lowered considerably--both individual and institution benefit.
If neither the individual nor the institution can afford to hire the experts or design complex systems to do the analysis, then they are both faced with a financial dilemma. Incorrect filing and withholding (or lack thereof) is costly, but the individual or institutional ways of determining the proper amounts with traditional consultants or systems can cost almost as much as incorrect compliance.
It would be desirable to have a system for automating the process of monitoring tax status for foreign individuals that does not require costly new mainframe computer payroll program systems or major modifications to existing ones.
Given the variety and changing nature of international income tax treaties, a system that could be modified as the treaties, laws or interpretations change would be beneficial for institutions and students and tax authorities.
If a relatively inexpensive system for monitoring international tax status could be made widely available to foreign students, scholars and researchers, the benefits of treaty benefits both governments intended they should get would be much more likely to be available to them to claim.
For institutions, who cannot afford major new systems, nor costly specialist advisors for foreign students, scholars and researchers, a relatively inexpensive system for monitoring international tax status and indicating which forms should be filed, would not only help the individuals, but could significantly lower the institution's risk of tax liability.